Why Cutting Taxes in the District of Columbia Will Lead to Economic Growth

About the Author

William W. BeachDirector, Center for Data Analysis and Lazof Family FellowCenter for Data Analysis

Testimony before the
District of Columbia Subcommittee / Appropriations Committee
-United StatesHouse of Representatives

On June 1, 1999, Mayor Anthony Williams
transmitted the District of Columbia's fiscal year 2000 operating
budget and financial plan to President Clinton and Alice Rivlin
(Chair of the District of Columbia Financial Responsibility and
Management Assistance Authority, "the Control Board"). This
important budget contains one of the most dramatic tax reduction
initiatives in the District's long history. If approved by
Congress, District taxpayers will save $892 million between FY 2000
and FY 2004 as the District reduces individual tax rates and
business taxes to levels more like those taxpayers face in Maryland
and Virginia.

The long economic expansion and wise
tax policy changes in the last two Congresses account in part for
the District's stunning decision to cut taxes. The tax policy
changes of the 1980s and prudent fiscal stewardship in the 1990s
produced the economic setting for what the District now proposes.
On the one hand, the environment for entrepreneurship that tax cuts
in the last decade enhanced led to vast improvements in economic
efficiency and productivity that we now see bearing abundant fruit.
On the other hand, the prudent management of state and federal
budgets and our money supply led to lower interest rates and
greater financial stability, especially as Congress and the
Administration delivered on their promise to balance the federal
budget. Congress's recent tax policy changes have only brightened
the economic setting: Lower capital gains tax rates, expanded
access to tax sheltered savings plans, and, yes, the child tax
credit have clearly signaled to taxpayers that the federal
policymakers want to accommodate continued economic expansion.

Additionally, the Taxpayer's Relief Act
of 1997 contained some important elements of Delegate Norton's
innovative District of Columbia Economic Recovery Act. While the
Congress did not adopt Delegate Norton's call for a District-wide
capital gains tax of zero, it did permit certain especially
distressed sections of the District to enjoy lower capital taxes.
While the Administration resisted the Delegate's wise call for a
flat tax in the District, the President did sign the legislation
that gave all first-time homebuyers a federal income tax credit of
$5,000. Evidence now streams into the District's economic
development offices that the tax credit and other Congressional tax
actions have made the District of Columbia one of the fastest
growing cities for new and previously owned home sales. Who would
have thought that possible just a few years ago?

Now the District owns a handsome fund
balance that is in surplus from its own revenue sources. Its fiscal
health appears real, and its management team (aided by an energetic
and talented Control Board) seems up to the important task of
long-term economic recovery.

With these factors in hand, the
District Council adopted the Tax Parity Act of 1999 to address one
of the most harmful legacies of D.C.'s past mismanagement: the high
District tax rates.

The District's three individual income
tax rates (6, 8, and 9.5 percent) are all higher than the
highest tax rates in Maryland and Virginia (5 and 5.75 percent,
respectively). Business taxes in the District are also higher than
in the surrounding states. D.C. businesses pay a franchise tax of
9.975 percent compared to corporate tax rates in Maryland and
Virginia of 7 and 6 percent, respectively. Personal and business
property taxes also are steeper in the District than in Maryland
and Virginia. The Washington Post reported in February that
D.C.'s own Office of Tax and Revenue found that a typical
middle-class D.C. family paid 50 percent more in taxes than it
would do in the Virginia suburbs.

In short, D.C. residents pay a
substantial tax premium to live and work in the District, and many
residents have found this premium far too high. In 1970, the
District of Columbia enjoyed a population of over 750,000. By 1997,
however, the District's population had fallen to 525,000. If
current trends continue, the District's resident population (and
much of its tax base) will shrink even further. According to WEFA
(an internationally recognized economic forecasting firm in
Philadelphia), current trends imply a population of 487,800 by the
end of 2004 and 471,900 by the end of 2009. At the same time, the
populations of the surrounding Virginia and Maryland counties are
expected to continue growing at near double-digit rates.

This downward drift in resident
population is mirrored by declines in total District employment.
District employment stood at about 248,000 at the beginning of
1999. If trends do not soon reverse themselves, the end of 2004
will see total employment fall to 219,000. By the end of 2009, the
Council could be trying to collect taxes from only 212,000 workers.
That number would represent a 15 percent drop in total employment
in a mere ten years.

Obviously, the District's school system
and historically higher rates of crime have played a part in the
hollowing out of the D.C. tax base, but high tax rates also matter.
If the District is to avoid a 40 percent fall in its population by
2009, the Council should take action on all of these fronts. The
District's Council argues that now is the time to begin work on the
tax leg of the District's set of problems. Certainly, with budget
analysts forecasting general fund surpluses over the next four
years and many economists expecting a continuation of the current
economic expansion, it is hard to argue with their timing.

Every good idea, however, has its
critics. While the general public reacted to the Tax Parity Act of
1999 with enthusiasm, some in the District fear that proposed tax
cuts will benefit only high-income taxpayers and that the
"productivity savings" that pay for a portion of the cuts will be
unrealized. The Council's decision to cut the lowest tax rate most
and the highest least addressed apprehensions about who would
benefit from the tax savings. Also, the jobs this policy change
should produce would benefit those who currently do not have work
as well as those D.C. residents looking to improve their economic
position.

The concern about productivity offsets
also is misplaced. The District just passed through a financial
crisis that focused the attention of the Mayor's Office as well as
the Control Board on numerous opportunities for reducing
government's cost while improving its services. In the FY 2000
budget, for example, the Mayor proposes implementing simple but
proven management tools for bidding and administering contracts.
This "managed competition" initiative may save the District $20
million in FY 2003. Additional "productivity savings" are expected
as the District finds old practices that high technology and
ordinary common sense can correct. We know, however, from the
efforts of large corporations to realize such productivity savings
that their achievement requires significant and substantial
attention: significant in the sense that the CEO must play a
central role in driving the process of change and substantial in
the hours spent by senior management on attaining higher quality at
lower cost. The Mayor also projects $15.7 million in "general
supply schedule savings" in FY 2003. This figure stems from growing
already realized supply savings in FY 1999 by no more than the rate
of inflation. In other words, if the District did no more than hold
the current line, it would meet this spending reduction target.

Criticisms about the District's tax cut
plan ran aground on the strength of the District's current and
near-term economy and on Congress's clear intent to support
economic growth in the nation's capital. Critics likewise ran
against the continued and pressing need to bring greater prosperity
to District residents. If declining population and employment are
not enough to spur critics of tax reduction to think again, then
they should contemplate a District unemployment rate that is still
nearly twice the national average. While most of the country has
succeeded in bringing the economic boom to Hispanics and
African-Americans, Washington remains a "neverland" of employment
if you are young, black, and hold a high-school degree.

Delegate Eleanor Holmes Norton heard
these same arguments against tax cuts when she attempted to secure
Congressional passage of the District of Columbia Economic Recovery
Act in 1997, a measure specifically designed to jump start the
District's then-sluggish economy. She wisely denounced them.
Delegate Norton and her colleagues Senators Joseph Lieberman
(D-CT), Sam Brownback (R-KS), and Connie Mack (R-FL) called for
federal tax law changes that would have created a flat tax for the
District, eliminated federal capital gains taxes in D.C., and given
all first-time home buyers a $5,000 tax credit. Then, as now, the
critics of this innovative proposal were more concerned with income
maintenance programs than with jobs, with funds for emergency food
programs than with micro enterprises. Despite a showing that D.C.'s
own revenues would rise with lower federal taxes, that thousands of
new jobs would be created, and that the suburbs as well as the
central city benefited from new economic life in Washington, the
critics prevailed and much of Delegate Norton's plan failed.

But not all of it. President Clinton
signed the Taxpayer's Relief Act of 1997 that contained the
District of Columbia tax credit for first-time homebuyers and a
limited version of capital gains tax abatement. Many observers
credit the tax credit with a significant portion of today's vibrant
D.C. housing market and the special capital gains treatment given
certain Washington neighborhoods with stimulating new business
development.

Indeed, these remnants of Norton's tax
proposal in concert with the reduction in the federal capital gains
tax rates from 28 to 20 percent and from 15 to 10 percent may have
a great deal to do the District's improved economy and its current
budget surplus. As the Center for Budget and Policy Priorities
correctly notes, budget surpluses bless the balance sheets of
nearly every state and most major municipalities in large part
because of unexpectedly high capital gains tax revenues. Reductions
in the after-tax cost of capital, which stem in part from the lower
taxes on capital gains, have stimulated housing construction and
purchases. Taxes from these activities also fill the coffers of the
District and other governments.

It is just these kinds of positive
economic effects that the Council can expect from its proposed tax
cuts. The WEFA/Heritage analysis of Delegate Norton's Economic
Recovery Act (which saved taxpayers almost as much as the Council's
plan) showed that disposable incomes throughout the metropolitan
area would rise by a total of $115 billion over a ten-year period,
and 15 percent of that increase would go to District residents.
This analysis also showed that employment would rise by 112,600,
with the District reversing its downward drift and gaining 24
percent of this increase. Likewise, District wage and salary income
(upon which the District raises most of its income tax) would
expand by $6.3 billion above its growth without the tax changes.
Perhaps the most telling result of all from this analysis of the
Norton plan was our finding that nearly all of the revenue decrease
came back to the District over a ten-year period in the form of new
taxes from new jobs and higher wages.

Tax policy stands at the center of our
effort to get public policy right for economic growth. Tax policy
mirrors our view of the role of government in everyday life and
parallels the level of spending and the diversion of resources to
the state. It reflects as well our opinions about the social worth
of achievement and financial prudence and shapes our practice of
the principle of equality before the law and equal access to due
process.

Tax policy matters, whether it is in
faraway places or the District of Columbia. We know from our study
of over 130 other countries that those with low tax rates on labor
and capital relative to the average have adopted other public
policies that promote growth: free trade, minimal restrictions on
the import and export of capital and labor, rule of law, stable
money, and light regulations on the use of one's private property
in production. We know as well that those countries with
below-average tax rates on labor and capital have long-term growth
rates that are about 0.6 of a percentage point higher than those
countries at or above the average.

Numerous studies conducted over the
past four years by The Heritage Foundation and by other think tanks
with economic specialization show that reductions in tax rates on
labor or capital--or both--lead to higher levels of economic
activity. Tax policy changes that provide credits or deductions for
some and not for others, however, have little effect on the overall
level of economic growth, even though they may achieve greater
equity in tax law. In fact, it is commonplace for economists to
give low economic growth scores to tax policy proposals that reduce
the tax burden on targeted classes of taxpayers. For example, the
recently enacted child tax credit, although important for reversing
the growing inequity in the code stemming from allowing the
personal exemption for children to lag behind inflation and the
exemptions for adults, hardly causes the standard economic models
to stop for breath. Drop the taxes on capital gains or reduce
marginal tax rates on ordinary taxable income, however, and these
same economic models register significant increases in economic
activity and long-term growth rates.

Getting tax policy right is a task that
knows no particular season. This year's opportunity for redirecting
tax policy down the seldom-trodden road to righteousness, however,
happens at a time of unexpected, rather large budget surpluses.
This bounty, however, raises a troubling question: Once the revenue
requirements of government have been determined in our
constitutional system of representative decision-making, must tax
revenues above the needs of government be returned to taxpayers
immediately; or does the national legislature have an expansive
authority to seize taxpayer income beyond the budget law it has
enacted?

Members of Congress and, indeed, the
general public may not see the important connection between how
this question is answered and future economic performance. If
Congress and the District get policy right, then District residents
are on the verge of unprecedented prosperity. If this opportunity
is missed, they may find themselves the subject of endless academic
essays diagnosing their failure to grab the chance for greater
well-being when the fortunes of economic events offered it.

William
W. Beach is Director of The Center for Data Analysis and
John M. Olin Senior Fellow in Economicsof The Heritage
Foundation,

About the Author

William W. BeachDirector, Center for Data Analysis and Lazof Family FellowCenter for Data Analysis